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Understanding Your College Savings Options

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This is a guest post from MLR @ MyLifeROI. This is a 3 post series and each post is going live this morning on three different blogs: Bargaineering, Green Panda Treehouse, & Poorer Than You. I will be posting a wrap-up post to tie it all together and summarize each article.

You are 22 years old. You have just spent the past four years paying tuition, room and board, books, food, utilities, transportation, etc. The worst part is that it is all getting more and more expensive beyond peoples’ expectations. Where does that leave you? In a mountain of debt upon graduation. For some of us that means letting our debt dictate a less than optimal career.

However, what are some ways that we could better prepare for our college education? And if it is too late for you, how can we better plan for our children’s education?

I will outline three ways: Savings Vehicles, Financial Aid, and Reducing Costs. Each section contains a sub-list of “to-do’s” that I advise you to look into!

  1. Post #1: Savings Vehicles, Bargaineering
  2. Post #2: Financial Aid, Green Panda Treehouse
  3. Post #3: Reducing Costs, Poorer Than You
  4. Post #4: Wrap up, My Life ROI

So you are thinking about ways to prepare for your child’s college education. College may be five years away for your child. Or perhaps it’s next year. Or if you are really on top of your game, your child may just be a thought in your mind. What savings vehicles are available to make paying for college easier? And in doing so, which way is least detrimental to your child as well?

Custodial Accounts

Custodial accounts, to put it simply, are accounts managed by an adult that are created for a minor who is under the age of 18 or 21. They are usually opened at either a bank, a brokerage firm or a mutual fund company. Custodial accounts don’t have as many advantages as the following two savings vehicles I will mention, so I won’t spend as much time on them. In other words, they have some big downfalls.

Generally, anything you do with a custodial account is permanent. If you transfer money into a custodial account it is stuck there. Why? You would need the consent of the account owner to take money from the account and legally the account is owned by the minor that you created the account for. If they are a minor they probably cannot give consent, legally. Thus, your change is permanent. Once your child turns 18 or 21 the assets are legally theirs. How mature were you at 21? Will you be upset if your child opts to take that money and spend it on a new car rather than a college education? If so, tough luck… it is their money and they have free reign on what to do with it.

If the child chooses to go to college, custodial accounts can be detrimental! The financial aid formula assumes the students themselves will contribute about 35% of their assets towards costs and the parents need to put up 6% of their savings. Custodial accounts count under the students assets, thus heavily weighting the formula and increasing the burden on the student. By inflating the child’s assets they will lose money on financial aid.

Also, one thing you will find with the following two vehicles is the ability to transfer money around between beneficiaries. You cannot do that with a custodial account. Why would you want to do that?

Let’s assume that you have contributed $30,000 for child A. Recently the stock market has taken a large dive and you also lost your job. You can only afford to put in $10,000 for child B. Would you feel OK leaving one child $30,000 and the other child $10,000 just because of how the market worked out? It would be nice to leave each of them $20,000, in my opinion.

Alternates? For college reasons, read on to learn about the Section 529 Plans and Coverdell Education Savings Accounts. For other reasons, a traditional IRA, roth IRA, or even a trust could be a better idea! To determine if you fall into this situation, consult a financial or estate planner.

Section 529 Plans

Section 529 plans are advantageous in plenty of ways. They are open to people of all income levels. Not only that, but you do not have to be a child’s parent to contribute to the plan. You can be a grandparent, a sibling, an aunt, or just a random philanthropic person if you would like. You can even contribute to your own 529 plan as long as you are planning to attend law school or medical school!

A lot of people shy away from investments because of the minimum contributions, effects on tax planning, and the possibility of other detrimental consequences as seen with a custodial account. However, with Section 529 Plans, you can often times contribute just $25/month. Compared to some of the minimum investments for IRAs and index funds… that is pennies! In regards to taxes, the 529 plan grows tax-free! In order to take advantage of this tax-free growth even more, maximum contributions have been created that do not have any gift tax consequences. The limit on contributions without gift tax consequences is $65,000/person or $130,000/couple over a 5 year span. This comes out to $13,000 per year.

When it comes time to apply for college, these plans can be used at any accredited school in the country. When applying for financial aid, Section 529 plans do NOT count under the students’ assets for the formula!

If the child decides to forgo college education, it is simple for the parent to transfer the plan assets to another beneficiary such as a younger sibling. And the child that skips college cannot force withdrawals unless they are for college expenses.

Coverdell Education Savings Accounts (Formerly Education IRAs)

Coverdell Education Savings Accounts (which will be referred to as CESAs) also have their advantages and disadvantages.

In regards to contributions, there are many more limits in place than in a Section 529 Plan. Only $2,000 a year can be contributed for each minor. There are income limits to make contributions, as well. If you are single or head of household the adjusted gross income (AGI) phase-out is between $95,000 and $110,000. Those AGI phase-outs rise to $190,000 and 210,000 for married filing jointly.

CESAs allow you more flexibility in terms of investment strategy. They allow you to invest in mutual funds, stocks, or bonds. 529 plans bind you to the portfolios that the state-sponsored plan offers.

Despite the income limits, any contributions made are after-tax just like a Roth IRA or Section 529 plan and they grow tax-free. Typically little to no account maintenance fees are charged and contribution minimums are also little to none. As long as the money is used for elementary, secondary, or higher education expenses the money is not taxed again when it is distributed. The important distinction here is that unlike the 529, CESAs can be used for elementary and secondary education. But, just like the 529, for higher education the money can be used for any accredited school (with more flexibility to private and nonprofit institutions for CESAs). If the child decides to forgo college the money can be rolled over into another family member’s CESA as long as they are under 30.

One large drawback from a Coverdell is that once the child reaches college age they take control of the account and manage the distributions. Whether you think they are responsible enough or not, they have the final say. If any money remains after the beneficiary turns 30, the money that is left is subject to taxes.
Conclusion?

For many people, the 529 plans are the most robust. They offer the most control for the custodian/parent even once the child has reached the age of majority. The fact that there are no income limits and anyone can contribute to the plan makes it much more flexible. The gift-tax free contributions are a great perk. The ability to roll the plan over to another beneficiary is a great benefit, too. If your child gets scholarships wouldn’t it be great to just roll that money into the younger siblings rather than lose some of the money to taxes? And finally, by using Upromise you can get extra money added to your 529 from partner companies.

Consult a professional to figure out what your exact situation requires but go into his consultation knowing your options. Do not start a custodial account because a friend says its the best option and find out you have hurt your child eighteen years later. And do not start a CESA because you want to pick your own portfolio when a state-sponsored portfolio in a 529 may work for you. Talk to a professional and go over your exact situation!

I hope this brief outline of 3 of the major savings vehicles people use for their child’s college education has been educational!

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5 Responses to “Understanding Your College Savings Options”

  1. Something to keep in mind on the 529 programs is the impact that it has on your FAFSA results..your EFC (Estimated Family Contribution).

    If the parents have a 529 program set up in their name it will be included in their asset calculation on the FAFSA. That is why it is probably best for the 529 to be set up in the name of a grandparent or trusted aunt/uncle since their information is not requested on the FAFSA.

    Good informative article!

  2. My Life ROI says:

    SSP –

    Good suggestion.

    Parents are only expected to put up 6% of their savings so it doesn’t weight the EFC calculation nearly as much as if you had set up a custodial account with the same dollar amount in your child’s name. BUT, that still leaves an advantage to setting up the 529 in the grandparent’s name (or as you mentioned.. other trusted person).

    Thanks for the feedback!
    MLR

    • Thanks MLR!

      To follow-up to your 6% comment: Approximately the first $40,000 in assets are not factored for the parents on the FAFSA as well. And of course, retirement and household equity never get calculated in. Unless of course the college requires a CSS form. That is usually where they get you on finding any “hidden” assets.

      I have not checked the other posts for this series but I am sure someone has probably made mention of this information though.

      Sorry to clutter your comments.. I just LOOOVE talking Financial Aid!

  3. Jessica says:

    My fiancee and I are of the types that have begun saving for college before we have any kids. We’re about 2 years away from having a baby with a name and SSN. Right now we’re auto-saving a good chunk of $ each month in Series I bonds to get ahead of the curve for college savings. It’s been a while since we set it up but if my memory serves me correctly, isn’t the interest earned on these bonds tax free if used for higher education? Any other information you can provide on using savings bonds to save for college?

    • Oh yes… that is still the case. Interest earned on savings bonds bears no tax as long as you have comparable educational expenses in the same year that you cash the bonds. However.. don’t take your savings bonds directly to the school that your student attends because they will just direct you onto your local bank to cash them in(common mistake). For further information, I.R.S. Publication Release 970 can give you the details


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